Fundamental analysis is a term you may have come across in the course of your investing journey. You’ll find that most professional analysts who research stocks for a living use one of two main forms of assessment – fundamental analysis or technical analysis.
Whilst we Fools don’t necessarily agree with that dichotomy, it still proves that an understanding of what is meant by fundamental analysis is very important.
What do we mean by fundamental analysis?
When someone refers to fundamental analysis, they are describing how an investor values a company. At its core, fundamental analysis is about assessing the ‘fundamentals’ of a business in order to determine its value, and by extension, an appropriate share price.
Fundamentals incorporate a range of factors but the primary focus is working out how much money is coming in and going out of a company. This might include external considerations, such as economic growth or inflation, and internal metrics, such as revenue growth or profitability.
Fundamental analysts use this data to determine whether the price that the market sets for a company’s shares is an accurate reflection of the company’s valuation. They then use this assessment to decide whether a share is worth buying (ie, the fundamentals tell the investor that the company is undervalued) or selling (the fundamentals indicate an overvaluation).
Fundamental analysis is often described as the opposite to technical analysis, which uses share pricing charts to determine the trajectory of a company’s share price.
How fundamental analysis works
Fundamental analysis is partly a game of probability. Two common questions that a fundamental analyst might ask are, ‘How likely is it that this company can continue to grow its revenue at x%’ or ‘How much of a market can this company capture?’.
Qualitative and quantitative analysis
A fundamental analysis investor might start the valuation process by looking at a company’s market capitalisation, its history and its place in the industry it operates in. A logical progression would be to look at the company’s financial statistics, such as how much revenue it generates and how much of this it keeps as earnings and profits.
A thorough examination of the company’s income statement, balance sheet and cash flow statement is vital here. Then, the investor might look at how these numbers have been growing (or shrinking) over time. This is referred to as quantitative analysis.
After developing a deep understanding of these numbers, the investor might then have a look at how the company is being valued by the market, perhaps contrasting its valuation against any direct industry or sector competitors using the price-to-earnings (P/E) ratio.
Following this, an assessment of external factors that might affect the company could be considered. This might include what kind of industry the company is in (growing or declining), whether the company has a ‘moat’ or intrinsic competitive advantage (perhaps a powerful brand), or how broader economic factors might affect its business (for example, a cyclical company would be harder hit in an economic downturn). This is known as qualitative analysis.
At the end of this process, if the investor decides a company is worth buying because it is undervalued, then they have to consider why the market has come to a different conclusion and whether ‘going against the crowd’ is a good idea.
Of course, every investor who calls themselves a fundamental analyst will have a different process and even different investing outcomes.
Fundamental analysis is a guidebook, not a rulebook.
When should investors use fundamental analysis?
We Fools think fundamental analysis is absolutely essential in making good long-term investing decisions. When you buy shares, you are really buying part-ownership in a business. Any good business owner will tell you that understanding the nuts and bolts of ‘your’ company is of paramount importance to understanding its future (and thus what its share price is likely to do over the long term).
If your neighbour asked you to go into business with them, wouldn’t you like to have a look at what kind of business he or she is looking to build first? You’d be asking questions like, ‘How is this business going to make money?’ and ‘What’s the competition like?’
Well, the same logic extends to buying ASX shares. Therefore, we think having a sound fundamental analysis process for share investing is a good idea for any aspiring investor. Almost all of the most successful investors, including the globally renowned Warren Buffett, use a form of fundamental analysis. There’s a good reason why!